A loss corporation that undergoes a change in ownership may find the
amount of taxable income that may be offset by its net operating losses (NOLs) is subject to limitation under Sec. 382. Unless the change date
occurs exactly on the date of the corporation's year-end, the
corporation will have to allocate its income or loss during the change
year between the "prechange" and "postchange"
periods. This allocation can have tremendous significance in determining
the NOL subject to the limitations of Sec. 382.

Sec. 382(b)(3)(A) provides the general rule that taxable income or
loss must be allocated ratably to each day in the year of the ownership
change. The IRS announced in Notice 87-79 its intention to issue
regulations that would allow a taxpayer to make a closing of the books
election with respect to taxable income or loss in the change year.
However, the Service mandated that the ratable allocation method must be
used until regulations were issued, unless a letter ruling had been
requested.

Several letter rulings were issued, stipulating that a taxpayer could
use a closing of the books method. However, as a condition, the IRS
mandated that the amount of income or loss that could be allocated to
the prechange period could not exceed the amount of taxable income or
loss for the entire year. The significance of this limitation can be
seen in Example 1, below.

Example 1: Loss corporation L, a calendar-year taxpayer, has an
ownership change on July 1, 19X5. L has an NOL carryforward of
$1,500,000 to 19X5.

The $250,000 is allocated entirely to the prechange period. The
allocation to the postchange period is $0. The NOL subject to the Sec.
382 limitation is $1,250,000.

As a result of the Service's position, L would only be able to
offset $250,000 of taxable income against the NOL, leaving a $1,250,000
carryforward subject to the Sec. 382 limitation. The IRS alleviated this
negative result in regulations proposed in 1992, by allowing for an
increase to the Sec. 382 limitation to the extent that postchange losses
were offset against prechange income. L would increase its Sec. 382
limitation by $750,000.

Final regulations issued on June 22, 1994 (which minimally modified
the proposed regulations) are effective for ownership changes occurring
on or after that date. Significantly, however, the limitation increase
rule did not make it into the final regulations.

The regulations maintain the general rule of ratable allocation but
allow for a closing of the books election made on a timely filed return.
The election is made as part of the information statement required by
Temp. Regs. Sec. 1.382-2T, and is irrevocable. The election does not
terminate the loss corporation's tax year as of the change date.

In the year of the ownership change, the taxable income or loss is
determined, for purposes of allocating income to the pre- and postchange
periods, without regard to capital gains or losses. Thus, capital items
are tracked separately from ordinary income or loss. The regulations
allow for offset of similar items in the pre-and postchange periods
without respect to the Sec. 382 limitation. However, recognized built-in
gains or losses must be allocated entirely to the postchange period.
Also, any income or gain recognized during the postchange period on the
disposition of assets transferred to the loss corporation for purposes
of ameliorating the Sec. 382 limitation is allocated entirely to the
postchange period.

The regulations mandate adjustments after the initial allocation to
each period. First, any modified capital gain net income (MCGNI)
allocated to each period is offset by any recognized built-in capital
losses and any capital loss carry-overs, subject to the Sec. 382
limitation. MCGNI is defined in Regs. Sec. 1.382-6(g)(4) as the excess
of capital gains over capital losses for the change year, excluding any
capital loss carryover from a preceding year. Finally, any NOL allocated
to each period is reduced by any remaining MCGNI in the same period, and
then by the MCGNI remaining in the other period.

Examples 2 and 3 demonstrate the differing results that may be
obtained if a loss corporation elects a closing of the books rather than
a daily ratable allocation. In Example 2, above, the loss corporation
will obtain a better result by making the closing of the books election.
This is a result of the Sec. 382 limitation, which serves to reduce the
amount of postchange period taxable income that may be offset by the
prechange loss.

In Example 3, on page 81, while the taxpayer ends up with the same
amount of NOL carryforward, the ratable allocation method yields
$100,000 as a postchange loss, which is not limited by Sec. 382.

Obviously, the regulations do not contemplate situations in which
corporations are unable to generate the information necessary to
accurately close the books as of a given change date. Assuming this
information exists, a loss corporation must factor in the amount of the
Sec. 382 limitation in relation to the tax attributes being carried
forward, as well as the amount of any postchange losses that can be used
in the future without limitation.

From Adam Yalowich, CPA, Fort Lauderdale, Fla.

COPYRIGHT 1995 American Institute of CPA's
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